The Outsourcing of Primary Activities:
Theoretical Analysis and Propositions
Roger Strange (University of Sussex)
ABSTRACT
There is a considerable literature comparing the virtues of markets and hierarchies as alternative
governance structures for economic transactions. But governance decisions are not simple
dichotomous choices, and there has been increasing recent interest in the ‘swollen middle’ of
hybrid organisational forms that combine market and hierarchical elements. One such hybrid is
outsourcing, which has become a topic of considerable contemporary interest both in business
circles and within the academic literature. The main contribution of this paper has been to
combine the insights of resource dependency theory, the resource-based view of the firm, and
transaction cost economics to provide both an explanation for the outsourcing of primary
activities and a set of testable propositions about firms’ propensities of outsource.
Key words:
externalization; outsourcing; resource dependency theory; resource-based view;
transaction cost economics
Address for correspondence: School of Business, Management and Economics, Mantell
Building, University of Sussex [e-mail: R.N.Strange@sussex.ac.uk]
Acknowledgements: I would like to thank Peter Buckley, Grazia Ietto-Gillies and Antonio
Majocchi for helpful comments on earlier drafts of this paper. My special thanks are due to
Howard Gospel. The comments of two anonymous referees are also gratefully acknowledged.
2
The Outsourcing of Primary Activities: Theoretical Analysis and Propositions
INTRODUCTION
There is a considerable literature comparing the virtues of markets and hierarchies as
alternative governance structures for economic transactions. But governance decisions are not
simple dichotomous choices, and there has been increasing recent interest in the ‘swollen middle’
of hybrid organisational forms that combine market and hierarchical elements. One such hybrid is
outsourcing, which has become a topic of considerable contemporary interest both in business
circles and within the academic literature. A range of managerial motives have been put forward
for the apparent rise of outsourcing as a corporate strategy in recent years, notably to enable the
lead firm to concentrate on ‘core competencies’, or to gain access to expertise and competencies
not available in-house, or to take advantage of economies of scale and/or scope enjoyed by
external suppliers. Much of the literature provides illustrations of outsourcing of ‘support
activities’ (Porter, 1985: 40-43) such as IT or other back-office services (Quélin and Duhamel,
2003; Berggren and Bengtsson, 2004), and here the above arguments clearly have some validity.
But such arguments appear to have less validity for many firms which have outsourced
‘primary activities’ (Porter, 1985: 39-40) in a range of industries which produce goods as diverse
as footwear, clothing, cars, or pharmaceuticals1. The footwear manufacturer Nike has long been
renowned for the fact that it does not own any manufacturing facilities, but subcontracts out the
manufacture of its products to independent suppliers (Donaghu and Barff, 1990). The clothing
industry, particularly in the United States, the United Kingdom and Continental Europe, has
undergone a ‘retail revolution’ (Gereffi, 1994: 104-105) over the last thirty years, and the
According to Porter (1985), these ‘primary activities’ include inbound logistics, operations (production), outbound
logistics, marketing & sales, and services. Porter categorises procurement, technology development, human resource
management, and firm infrastructure (accounting, legal, financial planning, quality assurance etc) as ‘support
activities’.
1
3
industry is now dominated by large retailers (e.g. J.C. Penney, Marks & Spencer), branded
marketers of fashion garments (e.g. Liz Claiborne), and branded manufacturers of standardised
garments (e.g. Levi Strauss). There is a sharp distinction between garment retailers and
manufacturers (Gereffi, 1994; Gibbon 2001), and most of the main garment retailers no longer
have any significant manufacturing interests. In car manufacturing, long a bastion of verticallyintegrated production, many observers have predicted that today’s major firms will become
‘vehicle brand owners’ with all parts’ manufacture and assembly undertaken by suppliers (The
Economist, 2002: 71). Indeed firms like Toyota are well-known for their systems of tiered
suppliers (Fujimoto, 1999). In pharmaceuticals, Astra Zeneca announced in September 2007 that
it was planning to outsource all of its drug manufacturing activities within ten years (The Times,
17 September 2007). Initially the company intends to outsource the manufacturing of the active
pharmaceutical ingredients, but will later move to outsource more sophisticated manufacturing
activities. Its ultimate aim, according to senior management, is to control the research, the
intellectual property, the branding, and the health and safety issues, but to outsource everything
else. And Astra Zeneca is not alone: other pharmaceutical companies (e.g. Pfizer) have also
begun outsourcing their manufacturing activities. In each of these illustrative cases (and similar
cases could be found in many other industries), it does not appear that the external suppliers have
any special expertise or competencies that are not available in-house, nor do they appear to enjoy
economies of scale and/or scope which the ‘lead firm’2 would not also be able to exploit.
This paper draws upon resource dependency theory, the resource-based view of the firm,
and transaction cost economics to provide a comprehensive explanation of the conditions under
We use the term ‘lead firm’ in this paper to refer to the firms (e.g. Nike, Levi Strauss, Toyota, Astra Zeneca) which
have outsourced significant primary activities within their production chains. A ‘production chain’ is defined as a
vertical series of exchange relationships that combine resources at each stage in order to produce and distribute a
finished good or service. Dicken (2007) comments that the ‘chain’ metaphor has been adopted by many writers, but
using slightly different terminology: value chain, commodity chain, supply chain, demand chain, filière. See also
Porter (1985), Sturgeon (2001), Raikes et al (2000), and Selen and Soliman (2002).
2
4
which lead firms resort to the outsourcing of primary activities, and of the reasons why such
outsourcing has grown in importance in recent years. It is argued that certain firms choose to
outsource primary activities within their production chains to independent suppliers, not because
of relative capability considerations, but because they are able to leverage their resources to
appropriate the rents from the chain whilst reducing their asset base. Furthermore, this ability to
leverage its resources enables the firm to maintain control over the activities within the chain,
even without equity participation in the subordinate suppliers. In short, we would suggest that the
outsourcing of primary activities should not be viewed simply as a manifestation of the classic
Coasian ‘make or buy’ decision but that it is a hybrid governance structure, that lies between pure
contract-based market relations and internal managerial hierarchy, for exploiting the firm’s
capabilities whilst retaining effective managerial control over the production chain.
The paper is structured as follows. The next section provides a working definition of the
term ‘outsourcing’, and briefly contrasts outsourcing with the related, but conceptually distinct,
phenomenon of ‘offshoring’. The third section contains a succinct review of traditional
explanations for why firms engage in outsourcing. The following section addresses the questions
of how the process of outsourcing of primary activities might be explained theoretically, and
what is driving the recent growth in such outsourcing? We then use the insights from this
discussion to advance a number of testable propositions delimiting the firm attributes associated
with firms which are likely to externalise the production of primary activities. The final section
considers some of the implications of the analysis, and suggests areas for further research.
THE DEFINITION OF OUTSOURCING
The term ‘outsourcing’ is used in this paper to refer to the procurement by a lead firm of
goods and/or services from independent outside suppliers, when those goods and/or services had
5
previously been provided internally within the firm3. Two points in particular should be stressed.
The first is that the goods and/or services had previously been provided internally within the firm,
so that outsourcing is a process which involves the firm externalising elements of its production
chain. This requires a physical ‘slicing-up’ of the production chain, and involves a change in the
firm’s boundaries. There is an organisational fragmentation4 of production (Venables 1999: 936).
The second is that the typical outsourcing contract is not a one-off arm’s length purchase of a
standard ‘commodity’, but involves an ongoing relationship between the firm and the outside
suppliers with the latter providing the goods and/or services to the former’s specification. The
transactions effected under the typical outsourcing contract are thus not pure market transactions,
even though the firm has no ownership rights over the external supplier.
The outsourced activities may be undertaken by suppliers located within the same country
as the firm, or may involve the relocation of production overseas. A related phenomenon is
‘offshoring’, but it is important to understand that outsourcing and offshoring are conceptually
different. Offshoring5 refers to the relocation of the production of goods and/or services overseas,
and thus involves an international fragmentation of production (Feenstra, 1998). The offshored
activity may or may not take place under the direct control of the firm: if it does, then foreign
direct investment (FDI) is involved. Thus sometimes outsourcing and offshoring take place
contemporaneously, but they may also happen independently. Most importantly, each strategy
involves different considerations and has different determinants.
TRADITIONAL EXPLANATIONS OF OUTSOURCING
3
See Espino-Rodriguez and Padrón-Robaina (2006: 51) for a list of many of the different definitions of outsourcing
used in the academic literature.
4
The term ‘vertical disintegration’ is also commonly used as a synonym for the ‘organisational fragmentation of
production’.
5
The terms ‘delocalisation’, ‘global outsourcing’, ‘super-specialisation’, ‘global production sharing’, and ‘coproduction’ have all been used in the literature as synonyms for offshoring.
6
As noted in the introduction, a range of managerial motives have been put forward in the
literature for the apparent rise of outsourcing as a corporate strategy in recent years, notably to
enable the firm to concentrate on ‘core competencies’, to gain access to expertise and
competencies not available in-house, and to take advantage of economies of scale and/or scope
enjoyed by external suppliers.
The first, and perhaps the most popular, explanation of why firms engage in outsourcing
is that they are concentrating on their core competencies (Prahalad and Hamel, 1990; Quinn and
Hilmer, 1994; Gilley and Rasheed, 2000), and are thus concentrating their resources and
capabilities on activities which have the greatest potential benefits in terms of improvements in
competitive advantage. The second explanation (Grant, 1991; Diaz-Mora, 2007) draws upon the
observation that all firms specialise in a limited range of activities because of the scarcity of
resources (Coase, 1937), and outsourcing allows the firm to complement its own scarce resources
with those owned by the external suppliers (Gottfredson et al, 2005). Outsourcing thus allows the
firm to address perceived deficiencies in its own resources and capabilities (Lorenzoni and
Lipparini, 1999). The third explanation (Monteverde and Teece, 1982; Abraham and Taylor,
1996; Chiles and McMackin, 1996) goes further by suggesting that the external suppliers are
better able, perhaps because they supply multiple clients or because they specialise in the
production a variety of similar outputs, to provide the requisite goods and services with greater
efficiency and at lower cost. This specialisation may also enable the suppliers to make product
and/or process innovations (Leiblein and Miller, 2003; Mol et al, 2005) that give rise to supply
cost reductions that benefit the firm, though it has been noted that suppliers exhibit different
levels of improvement capability (Peteraf, 1993).
A common feature of the above explanations is that outsourcing is the preferred
organisational form because the external supplier is somehow able to provide the requisite goods
7
and services at lower cost than the firm is able to do internally. These arguments clearly have
merit as explanations for the growth of outsourcing of IT and other back-office services, but they
are less convincing in the illustrative cases cited in the introduction. Does Nike outsource the
manufacture of its footwear because an external supplier can manufacture at lower cost than the
company could do itself at an overseas subsidiary? Can outside firms manufacture
pharmaceutical ingredients more efficiently than Astra Zeneca or Pfizer? In all these cases, the
lead firms have chosen to externalise the production of primary activities that had previously
been undertaken in-house, but it not obvious that there are any direct cost benefits. So why is this
happening, and why is it happening across a range of industries in the latter part of the twentieth
and early part of the twenty-first centuries?
One common argument (see, for example, Malone et al, 1987; Brynjolfsson et al, 1994;
Evans and Wurster, 2000) is that advances in information and communication technologies
(ICT), and in particular the internet, have reduced substantially the transaction costs of effecting
exchanges through the market. Thus it is suggested that these developments should lead to less
vertical integration, and moreover favour smaller, more specialised firms which are not
encumbered with obsolete assets and archaic systems and mindsets. But these same advances in
information and communication technologies have also facilitated the central control and
coordination of activities that are both geographically dispersed, and many authors have
suggested that such developments thus favour greater vertical integration. Indeed Coase (1937:
397) pointed out6 seventy years ago that ‘Changes like the telephone and the telegraph which
tend to reduce the cost of organising spatially will tend to increase the size of the firm. All
Coase (1937) did, however, concede ‘that most innovations will change both the costs of organising and the costs
of using the price mechanism. If the telephone reduces the costs of using the price mechanism more than it reduces
the costs of organising, then it will have the effect of reducing the size of the firm.’ Clearly, however, he believed
that most innovations led primarily to reductions in the costs of organising.
6
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changes which improve managerial technique will tend to increase the size of the firm.’ A more
contemporary discussion is provided by Afuah (2003), who suggests that the emergence and
diffusion of the internet has reduced not only transaction costs, but also component production
and bureaucratic coordination costs. He suggests that the internet may either expand or shrink
firm boundaries, depending upon the firm’s determinants of costs, moderated inter alia by the
firm’s organizational technology. So how may the growth in the outsourcing of primary activities
be explained, if neither ICT advances nor the traditional arguments provide a compelling
rationale?
WHY OUTSOURCING?
How may the process of outsourcing of primary activities be explained theoretically? Our
starting point is the exchange relationship between a supplier (A) and a buyer (B) and, in
particular, the power structure of the relationship between the two independent parties. According
to resource dependency theory (Cook, 1977; Pfeffer and Salancik, 1978; Pfeffer, 1981; Cook and
Emerson, 1984; Ulrich and Barney, 1984), limitations on the availability of resources foster
specialization and necessitate organizational interdependence, and thus create resource
dependencies. Each party will try to alter its dependence relationships by acquiring control over
resources that either minimises its dependence on the other party, or maximises the other party’s
dependence on itself. Power derives from dependence in exchange relationships and, the more
power a party has, the more influence it has to determine the nature of the exchange between the
organizations, both in terms of the form of the interaction and the terms of the exchange.
Furthermore, the power of each party in the exchange relation is increased as the scope of the
resources (or the numbers of different resources) mediated by the party increases. If a party has
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alternative sources available in an exchange network, then its dependence is less and it will have
more bargaining power in terms of negotiating the terms of the exchange.
The fundamental question to be asked about the exchange relationship is thus how scarce
are the resources on either side of the exchange (Cox et al, 2002: 34)? According to the resourcebased theory of the firm (Lippman and Rumelt, 1982; Wernerfelt, 1984; Barney, 1986, 1991;
Dierickx and Cool, 1989; Peteraf, 1993; Teece et al, 1997), each party will typically possess
some heterogeneous capabilities and resources, which may be both valuable and hard for
competitors to imitate. The absence of competitors with imitative or substitute resources provide
the basis for parties to earn entrepreneurial rents: i.e. to earn profits in excess of the costs of
production and which are not eroded by normal competition. The capabilities and resources
owned by each party may be valuable, but will only sustain a competitive advantage if there are
ex post limits on their acquisition and/or imitation by potential competitors. These limits are
provided by the existence of ‘isolating mechanisms’ (Rumelt, 1984, 1987). One such isolating
mechanism is the allocation of property rights by the State, in the form of patents, trademarks,
licenses etc. But, as Rumelt points out (1987: 146-8), no such legal protection exists for most
product, process, or supply chain innovations, but that there are a variety of potential first-mover
advantages that make it costly for followers to duplicate an innovator’s position. These
advantages may include economies of scale, information impactedness, response lags,
organisational learning, buyer evaluation and buyer switching costs, reputation effects,
communication goods effects, and advertising and channel crowding. The greater the protection
afforded the firm by any or all of these mechanisms, the more scarce will be its resources, and
hence the more it will be able to resist the appropriation of its rents, at least in the medium-term7.
7
See also Dyer and Singh (1998) on isolating mechanisms.
10
We may thus construct a matrix of possible power structures for the exchange – see
Figure 18. The situation in the top left-hand quadrant is that, although both A and B possess
resources that the other requires, there are plenty of alternative sources so that neither A nor B
enjoy a position of power relative to the other. In contrast, in the opposite quadrant, both have
scarce resources that the other values, and this generates a situation of bilateral dependency or
interdependence. The other two quadrants refer to situations where one actor has dominance over
the other because of differences in the relative scarcity of their resources.
***** Figure 1 about here *****
But an understanding of the power structure of the relationship between A and B is not
sufficient to explain how that relationship will be organised. It is also necessary to take into
account the relative costs of effecting the exchange through the market or through a hierarchical
relationship. Transaction costs economics (TCE) has long provided an explanation of firms’
boundary choices by focusing on the minimisation of transaction costs. TCE theory has its
origins in the paper by Coase (1937) who pointed out that there were costs involved in using the
price mechanism to coordinate the provision of goods and services through arm’s length
contracts. These costs include not only those involved in effecting the exchange, but also the
costs of measuring and monitoring performance and the costs associated with negotiating,
monitoring, and enforcing the contract. If such costs are sufficiently large, then Coase maintained
that the firm would emerge to provide more efficient central coordination.
More recent work has tried to identify the conditions under which such transaction costs
would be significant (Williamson, 1975, 1985, 1996). Williamson argued that transactions are
characterised by differing degrees of asset specificity and uncertainty, and that transaction costs
8
Cox et al (2002) provide a similar treatment of potential power structures but, unlike us, their main concern is not
with the boundaries of the firm.
11
may be minimised by assigning appropriate governance structures to different transactions.
Furthermore, he suggested that the parties to such transactions are both subject to bounded
rationality and predisposed to opportunistic behaviour. This combination of uncertainty and the
parties’ bounded rationality means that contracts are necessarily incomplete. Although this
provides scope for flexibility, it also creates an environment for opportunistic behaviour by one
party or the other in the exchange, which may be enhanced by information asymmetries between
the parties. In such circumstances, the parties to the exchange might attempt to establish credible
commitments to counter the risks of opportunism or, if the associated costs are substantial
enough9, might choose to internalise the transaction within a vertically-integrated hierarchy (the
firm). Thus, if the transaction costs of undertaking a market exchange are high, then TCE
suggests that a hierarchical solution will be preferred. But TCE does not take account of the
power structure in the exchange relationship. As Williamson (1998: 30) acknowledges, TCE has
been widely applied to exchanges of intermediate products10 because ‘the two parties can be
presumed to be risk-neutral and, roughly, to be dealing with each other on a parity [emphasis
added]. Each has extensive business experience and has or can hire specialized legal, technical,
managerial, and financial expertise.’ But, as the above discussion makes clear, we would argue
that the contracting parties often do not deal with each other even on a rough parity. We would
thus suggest that the preferred organisational form for the exchange relationship thus depends
both upon the power relationship between the parties and the relative transaction costs of
effecting the exchange though the market or within a hierarchy. Figures 2 and 3 detail the eight
9
Notwithstanding the avoidance of market transaction costs, the transfer of intermediate products within the firm is
still costly as it requires the functioning of complex internal information communication systems, organisation
structures, and accounting systems.
10
In contrast to contracts for labour, with consumers, or for capital.
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possible outcomes, taking into account the relative scarcities of the supplier’s and the buyer’s
resources, and whether market transaction costs are high or low.
Suppose first that the supplier (A) possesses scarce resources that are of value to the buyer
(B), whilst at the same time having many alternative customers for its output: B is thus in a
position of dependence with little power in negotiating the terms of the exchange. If the costs of
effecting the transaction through the market are also relatively high – see the bottom left quadrant
of Figure 2 – then there will be an incentive for B to internalise the transaction though backward
vertical integration, and thus ensure a stable supply of inputs of the requisite quality. This
situation corresponds to the traditional approach in the early Twentieth Century of Ford and other
automobile companies, who tried to reduce costs by bringing together the manufacture of the cars
and their component parts. A second possibility is that there are few potential buyers but many
alternative suppliers, hence A is the one in the position of dependence. If the costs of effecting
the transaction through the market are again relatively high – see the top right quadrant of Figure
2 – then there will be an incentive for A to internalise the transaction though forward vertical
integration. Examples might include major airlines taking over the activities previously
undertaken by independent travel agents, and the acquisition of cinema chains by film companies.
***** Figure 2 about here*****
If both parties possess scarce resources that are valuable to the other, then they are
interdependent – see the bottom right-hand quadrant of Figure 2. There is then a measure of
mutual interest between the contracting parties, and the organisational solution to effecting the
exchange will reflect this. Given the assumed high transaction costs of undertaking the
transaction through the market, it is likely that the two parties will establish a joint venture with
the respective shareholdings reflecting the relative scarcity and value of the resources held by
each party. The final possibility is that there are many potential suppliers and also many potential
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buyers – see the top-left hand quadrant of Figure 2 – so that neither A nor B currently enjoys any
power in the exchange relationship. Given that both parties operate in competitive markets, the
scope for opportunism by one party or the other is heavily circumscribed but there may yet be
scope for post-contractual ‘hold-up’ if the costs of searching for alternative transactors are
suitably high. There will thus be some incentive to formalise the exchange relationship, perhaps
through a joint venture or maybe through some non-equity form of long-term contractual
arrangement. There is again a measure of mutual self-interest.
In the four outcomes described above (with the possible exception of the last), the result is
that a vertically-integrated firm emerges which ‘makes’ in-house the input provided by A. It may
also be noted that, if A and B undertake their activities in different countries, then the resultant
firm will be a multinational enterprise (MNE).
In contrast, if the transaction costs of effecting a market exchange are relatively low, then
TCE suggests that a more ‘market-based’ solution will tend to emerge, although once again the
nature of that solution will depend crucially upon the power structure – see Figure 3. Thus when
neither party possesses scarce resources – see the top left-hand quadrant - and the transaction
costs are low, it is likely that an arm’s length exchange will take place. This is the economist’s
competitive market, where neither party to the transaction is able to call upon any isolating
mechanisms. Neither party thus has any power over the other, but then neither is in a position of
resource dependence. This is the typical ‘buy’ situation in most supply relationships: there is no
imperative to internalise the transaction because the costs of effecting the exchange through the
market are lower than the alternative costs of transferring the intermediate products within a firm.
***** Figure 3 about here *****
In contrast, if both parties possess scarce resources – see the bottom right-hand quadrant –
then there is a bilateral monopoly. It is difficult to conceive of a real-world example of bilateral
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monopoly involving different actors within a production chain, because their mutual dependence
would be such that there would be bargaining over both price and quantity, and it is highly
unlikely that the transaction costs of effecting a market exchange would be low. The likelihood is
that the market transaction costs would be substantial enough to favour integration.
The remaining two possible outcomes correspond to the situations where one party enjoys
position of dominance over the other, and there is a situation of unequal bargaining power. In the
bottom left-hand quadrant of Figure 3, it is the supplier (A) which possesses the scarce resources
so that the buyer (B) is in the position of dependence. There is thus (as above) an incentive for B
to internalise the transaction, but it may be that the relative sizes of the two parties are now such
that the costs to B of implementing a hierarchical solution are too high. Meanwhile A is content
with the market solution, as its power enables it to determine the terms of exchange so B simply
pays a premium price for A’s output. An example might be the supply of popular children’s toys
to stores at Christmas time. No store could possibly afford to acquire any of the major toy
manufacturers, so they have to accept restricted supplies and higher prices.
The final possible outcome is that depicted in the top right-hand quadrant of Figure 3.
Here it is the buyer that possesses the scarce resources, and the supplier which is in the position
of dependence. The buyer thus has more bargaining power, and thus is able to determine the
nature of the exchange between the parties, both in terms of the form of the interaction and the
terms of the exchange. The supplier (A) may wish to internalise the transaction but B is content
with the market solution, and the situation will persist if the relative sizes of the two parties are
such that the costs to A of implementing a hierarchical solution are too high. The buyer (B) is
thus able to insist upon assured supply at a given specification to a minimum quality and at a low
price. This is the situation that is apparent in many outsourcing arrangements, such as the
examples cited above of Nike, Levi Strauss, Toyota, Astra Zeneca etc. The buyers all possess
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scarce resources, which act as powerful isolating mechanisms and enable them to resist the
appropriation of the rents. In the cases of Nike, Levi Strauss, and the other clothing companies, it
is the possession of brand names (with the associated substantial expenditure on advertising) that
confers the power in their relationships with the suppliers and enables them to externalise
production. In the case of Toyota, it is the brand name, the sheer size of the company and the
spread of its distribution network. And in the case of Astra Zeneca, it is the R&D expenditure, the
drug patents, and the privileged access to the medical communities. In all cases, the common
factor that provides the rationale for the outsourcing is the asymmetry of power between the
buyer and the supplier.
Two final points should be emphasised. First, the typical production chain involves not
just one, but an extended series, of dyadic exchange relationships such as that between the
supplier (A) and the buyer (B). Global Commodity Chain (GCC) analysis (Gereffi, 1994, 1999)
suggests that profitability will be highest in those segments of the production chain where the
parties possess valuable and hard-to-imitate resources, and where these resources are
characterised by significant isolating mechanisms that permit protection against the appropriation
of the rents. Second, it should be apparent that the outsourcing of primary activities does not
come about as a result of the lead firm focusing on its core competencies, or taking advantage of
external competencies, or reducing costs by taking advantage of suppliers’ potential economies of
scale or their ability to provide better service quality. Rather the lead firm opts to outsource its
manufacturing because its resources and capabilities permit the appropriation of the total rents
from a smaller asset base, even though there are no direct cost advantages. One could couch this
proposition from a resource-based perspective that the lead firm is simply taking advantage of its
capabilities in coordinating the activities along the production chain, but this is close to being a
tautological statement: the key to the ‘improved’ performance of the lead firm has not been
16
greater efficiency but rather its ability to leverage its power over its suppliers. In the following
section, we develop these insights into a set of testable propositions about the firm attributes that
are likely to be associated with a high degree of outsourcing.
PROPOSITIONS
The above analysis suggests that the level of engagement of lead firms in the outsourcing
of their primary activities will depend both upon the power structure of the exchange relationship
with its suppliers, and upon the relative costs of effecting the exchange through the market or
through a hierarchical relationship. In other words, outsourcing should be more prevalent in firms
(a) which possess resources and capabilities that are considered valuable by their suppliers, and
which are scarce because potential competitors are unable to acquire or develop suitable
substitutes; (b) which use external resources and capabilities that are relatively abundant; and (c)
whose transaction costs of acquiring intermediate goods and services through the market are
relatively low. In this section, we develop these insights into a set of testable propositions about
the firm attributes and industry conditions that are likely to be associated with a high degree of
outsourcing11.
We first consider which firm attributes are least conducive to the ex post imitation and
substitution of the lead firm’s resources by potential competitors, and which are thus likely to be
scarce and underpin a position of power in the exchange relationship. First, there is the extent to
which the firm provides customised products to its final consumers. As noted above, several
authors have argued that the widespread diffusion of ICT has substantially reduced the
11
At any point in time, the average level of vertical integration will typically vary by industry, due to a range of
technological, institutional and historical factors. An appropriate measure of outsourcing for any firm might thus
consider the change in the ratio of its cost of the bought-in goods and services to the total cost of bringing the final
goods to market. An appropriate time period would need to be specified for the change to take place. Diaz-Mora
(2007) reviews various measures of outsourcing intensity used in the limited empirical literature on the subject: all
focus on the level, rather, than the change in the ratio of bought-in goods and services.
17
transaction costs of effecting exchanges through the market, and thus may be credited with
facilitating the growth in outsourcing. Certainly ICT has reduced some market transaction costs,
notably those associated with identifying and comparing possible partners, and coordinating
geographically-separate activities. But it will have little effect upon the costs of negotiating and
enforcing contracts, particularly when there are imperfect markets for intermediate goods and/or
when firm-specific tacit knowledge is involved. Indeed, it is possible that the widespread
availability of the internet might in such circumstances have increased the possibility of
opportunistic behaviour, and thus favour greater integration. But the development of the new
technologies not only affects the relative costs of market and hierarchy in ways that vary across
sectors, but it also has a marked impact upon the potency of the isolating mechanisms that enable
agents to earn sustainable rents. Buyer switching and evaluation costs will typically be reduced
(Bakos, 1997), response lags will be shortened, learning by imitative producers will be
facilitated, information impactedness will be reduced, and alternative marketing and distribution
channels will emerge. At the same time, many of the advantages accruing from property rights
will be eroded by the liberalisation of trade and investment worldwide, as various barriers to
entry (including those related to economies of scale) become less important.
In short, the adoption of the new technologies has both increased competition between
suppliers at various stages of the production chain, and also shifted power within the chain away
from suppliers towards buyers. As recent developments such as ‘lean retailing’ (Abernathy et al,
1999), ‘mass customisation’ (Pine, 1993), and ‘demand chain management’ (Selen and Soliman,
2002) imply, the crucial stage of the chain is increasingly control over the interface with the final
customer with many firms putting greater emphasis on their downstream activities (Wise and
Baumgartner, 1999). We would argue that the extent to which the lead firm provides customised
products, perhaps through preferential access to the final customer (Ghemawat, 1986), provides
18
the basis for a significant isolating mechanism that enables the firm not only to resist the ex post
dissipation of its rents but also to outsource the production of intermediate goods and/or services.
Thus our first proposition is that:
P1:
The degree of outsourcing will be greater for firms with a high degree of product
customisation.
In this regard, one very important resource is brand-name capital. Osegowitsch and
Madhok (2003: 28-9) comment that ‘in many mature industries, the product has reached levels of
performance that already satisfy the requirements most customers. Further refinements of the
technical/functional performance of mature products tend to confront severely diminishing
returns… In a bid to escape the commoditization of their core product or service, corporations are
desperately trying to differentiate themselves from competitors. Where previously they aimed for
differentiation based on the technical/functional merits of their offerings, they now supplement
them with sophisticated downstream services [and] the adoption of total brand management.
Managers in mature industries as diverse as banking, cars, airlines, foodstuffs, beer, utilities, and
resources have embraced branding in an effort to create a differentiated identity for their wares.’
Gereffi (2001: 33) also claims that brands are a way to resist commoditization when production
chains disintegrate as a result of externalisation. He suggests that ‘sellers use brands to lock in
customer relationships and to compete when reach (choice) goes up. Thus building brand
awareness is a fundamental challenge and a major source of market power for firms [in buyerdriven production chains].’ To the extent that consumers place value upon a particular brand, and
competitors are unable (because of legislation on the protection of intellectual property, or
otherwise) to copy the brand, then the owners of the resource will be able to outsource the
manufacture of the good safe in the knowledge that there is a strong isolating mechanism which
will prevent the dissipation of the rents. Thus:
19
P2:
The degree of outsourcing will be greater for firms with high levels of brand name
capital.
Next we consider the circumstances under which the external resources and capabilities
sought by the lead firm are abundantly available, and thus reinforce the firm’s power in the
exchange relationship. First and foremost, there is the thickness of the market for the intermediate
goods and services, in terms of the number of potential suppliers and the extent of the search
costs. If the lead firm has made a relationship-specific investment and there are only a few
potential suppliers of the required intermediate goods and services, then the potential for
opportunism is severe and the lead firm may choose to vertically integrate to alleviate the
possible hold-up problem and ex post bargaining difficulties. On the other hand, if there are a
large number of potential suppliers of suitable inputs12, then the lead firm will have more
bargaining power, particularly if its purchases account for a significant proportion of the
supplier’s business. In such cases, as illustrated in the numerical example above, the lead firm
may choose to outsource production. Furthermore search costs are reduced in thicker markets
(Grossman and Helpman, 2002), and this too should favour outsourcing. Thus:
P3:
The degree of outsourcing will be greater for firms which use intermediate goods
and services for which there are many potential suppliers.
Outsourcing can only take place if the technology of production is such that the
production chain can be split into different stages that can be carried out in different locations.
This spatial disaggregation may take place within a single country. Antras (2003) demonstrates
theoretically that outsourcing increases in attractiveness as the capital-intensity of the process
decreases. If the different stages in the chain are characterised by different factor intensities, and
12
McLaren (2003) suggests that the outsourcing decision may be endogenous in that there will only be a significant
number of non-integrated suppliers if other firms also choose to outsource rather than to vertically integrate.
20
the costs of transporting the intermediate goods are low enough to make the process
economically viable (Deardorff, 2001), then it is likely that the outsourcing arrangement will be
concluded with a foreign supplier as factor price differentials are generally more pronounced
between countries. Production will thus be offshored as well as outsourced, and the international
fragmentation of production will typically give rise to new patterns of international trade. For a
lead firm located in a high-wage developed country market, the potential for outsourcing – both
in terms of the numbers of competing suppliers and the scope for leverage – will be greatest if the
intermediate goods and services are labour-intensive products. Thus:
P4:
The degree of outsourcing will be greater for firms that use a large proportion of
labour-intensive intermediate goods and services.
As indicated in the previous section, the existence of power asymmetries between the lead
firm and its suppliers does not provide a sufficient explanation for the chosen governance
structure to be an outsourcing relationship. It is also necessary to establish the conditions under
which market transaction costs are likely to be lower than the costs of hierarchical coordination.
Four firm attributes are likely to be associated ceteris paribus with low market transaction costs:
firm size, the technological sophistication of the intermediate goods being exchanged, the firm’s
sourcing experience, and the volatility of demand for the firm’s output.
The first attribute is the size of the firm. The ‘traditional’ explanations of outsourcing
suggest that there should be an inverse relationship between firm size and the degree of
outsourcing, as small firms will wish to take advantage of the economies of scale and scope
provided by external suppliers whilst large firms are more likely to be able to provide a wider
range of expertise and competencies in-house than small firms. However, agency theory
considerations suggest that there are strong theoretical reasons to expect a positive relationship.
The costs of effecting transactions through the market include those associated with searching for
21
suitable partners, the measurement and monitoring of performance, those related to establishing
and enforcing the contract, and those related to effecting the exchange. Large firms are more
likely to have the necessary resources to facilitate the search for suitable partners, to monitor the
performance of any suppliers, and will typically have more experience of contract enforcement.
In contrast, small firms may be obliged to limit the search for potential partners, and may not
have the resources to monitor and enforce the contracts effectively (Tomiura, 2005).
Furthermore, large firms are more likely to have the bargaining power to extract safeguards for
their vulnerable relationship-specific investments (Subramani and Venkatraman, 2003). In
conclusion, it is likely that market transaction costs will be lower for large firms.
A second important attribute will be the technological sophistication of the intermediate
goods and services that are exchanged. If the intermediate goods in question are technologically
sophisticated, then it is likely that both partners will have made high levels of transaction-specific
investments, and moreover that high levels of tacit knowledge will be involved on both sides.
Hold-up and other potential ex post maladaptation costs will be more severe, and the likelihood
of opportunistic behaviour will be higher. Furthermore the potential rents that might be
appropriated by opportunistic partners will be higher, whilst the contract negotiations are likely to
be more complex. In such circumstances, the market transaction costs are such that a hierarchical
organizational solution would be preferred in order to align the interests of the exchange parties though, as indicated above, the exact form of that solution will depend upon the relative scarcity
of the buyers’ and sellers’ resources. In other words, it is likely that market transaction costs will
be lower for firms which use low-tech intermediate goods and services.
A third important attribute that is likely to mitigate market transaction costs is sourcing
experience. Following Leiblein and Miller (2003), firms with greater experience of sourcing
externally are likely to have developed the necessary organizational routines to enable them to
22
collaborate efficiently with a broad range of suppliers. ‘Experience’ in this sense might be
defined by reference to both the extent of external sourcing and the duration of that external
sourcing. Experienced firms are more likely to select better partners, organize relationships more
effectively, and anticipate and respond better to market or technological contingencies over time.
In short, the costs of effecting transactions through the market should be lower for firms with
greater sourcing experience.
Fourth and finally, Buckley and Ghauri (2004) note that volatility has become a much
more significant feature of the global economy since the 1980s, and this has led firms to search
for more flexible forms of organisation13. In situations where market demand is stable or
predictable, the firm might opt for the necessary resource commitments to make the requisite
intermediate goods and services in-house. But if market demand is uncertain or volatile, then
vertically-integrated production would provide rather less flexibility than market contracting
(Carlson, 1989; Klein et al, 1998; Leiblein and Miller, 2003). Greater outsourcing would provide
the firm with real options to change its use of intermediate goods and services relatively easily
and at lower cost, and would allow the firm to avoid various fixed costs.
DISCUSSION AND CONCLUSIONS
The approach in this paper has been theoretical, and has addressed the conditions under
which a lead firm might outsource its primary activities to an independent supplier in preference
to adopting an alternative governance structure. The traditional explanations for outsourcing are
applicable to a limited range of instances of support activities (typically IT and other back-room
services) in which the external suppliers are able to provide the requisite goods and/or services
13
See also Buckley and Casson (1998) who suggest that the three main reasons for the increased volatility are the
international diffusion of modern production technology, the liberalisation of trade and capital markets, and
increased exchange rate fluctuations following the breakdown of the Bretton Woods system.
23
more efficiently than the lead firm. However, these explanations do not provide a compelling
rationale for the outsourcing of primary activities in many other circumstances, nor do they
identify the types of firms that are more likely to outsource.
An alternative, but complementary, perspective comes from the work of Chandler and
Langlois. In The Visible Hand (1977), Chandler chronicled how, in the late nineteenth and early
twentieth centuries, the coordination needs of high-throughput technologies, and the abilities of
contemporary institutions and markets to meet those needs, had led to the growth of the large
vertically–integrated firm. According to Langlois (2003), the process of the division of labour
predicted by Adam Smith as a response to the growing extent of the market always tends to lead
to a finer specialization of function, but that the components of the process (markets, institutions,
technology) change at different rates. Langlois asserts that the managerial revolution witnessed
by Chandler as a replacement for the invisible hand of the market was an adaptation to a
particular set of historical circumstances, during which the costs of coordinating though markets
were high because the existing market-supporting institutions were inadequate for the profitable
opportunities offered by the new technologies. In his ‘vanishing hand’ hypothesis, Langlois
suggests that managerial hierarchies are second-best solutions that emerge in the absence of
better alternatives but that, given time and a greater extent, markets ‘catch up’ and it starts to pay
to delegate more and more activities. Langlois further suggests that, by the late twentieth and
early twenty-first centuries, the extent of the market had grown and the institutions to support
market exchange had evolved, and hence the vertically-integrated firm was increasingly
succumbing to the forces of specialization: the result was widespread vertical disintegration or
outsourcing.
The process of manufacturing outsourcing is associated with a narrowing of the formal
boundaries of the firm. But, given the degree of control that the lead firm is able to exert over
24
subordinate parties in the production chain, this raises questions about whether a more useful
definition of the ‘firm’ might incorporate various quasi-market transactions, such as those
involving outsourced activities, over which the firm has substantial control (Richardson, 1972;
Ietto-Gilles, 2002). This echoes similar points made by Hymer over thirty years ago (Cohen et al,
1979: 248; Strange and Newton, 2006), and by Cowling and Sugden (1987, 1998: 67) when they
define the modern corporation as ‘the means of coordinating production from one centre of
strategic decision-making’. There are also interesting historical parallels between the process of
outsourcing manufacturing and the system of ‘putting-out’ under which most non-agricultural
work was organised prior to the Industrial Revolution. Under the putting-out system, merchants
contracted with individual workers, or families, who worked at home and were willing to accept
low piece rates. Most labourers were hirelings, generally tied to a particular merchant, who used
their own machinery to turn raw materials provided by the merchant into intermediate and
finished goods which were then purchased by the merchant. The putting-out system was
eventually superseded by the factory system, though there has been considerable debate as to
whether this was because the latter was more organisationally efficient (Landes, 1986) or because
the former did not permit the merchant-entrepreneur to extract sufficient surplus from the
labourers (Marglin, 1974). We would suggest, following Hymer and Marglin, that outsourcing
provides a means by which modern merchants (the retailers and brand-name merchandisers) in
buyer-driven production chains may maximise their surplus.
This leads on to the question of who gains, and possibly who loses, from the ‘slicing-up’
of the production chain. The potential benefits to the firm undertaking the outsourcing seem clear
enough from the arguments above, and include higher profitability and the possible gains from
25
access to the expertise and competencies of external suppliers14. Notwithstanding these potential
benefits, there will only be a positive empirical relationship between outsourcing and firm
performance if firms choose correctly when to outsource, and when not to, and also administer
the outsourcing relationship effectively. Moreover, as Cook (1977: 67-68) points out, the use of a
power advantage to obtain increased rewards increases the firm’s dependence upon the supplier
over time. Over time, the exchange relationship tends towards balance unless the firm counteracts
this tendency by only forming short-term contractual relations. The very process of outsourcing
undermines the power asymmetries that enable the lead firm to appropriate the rents from the
production chain15. This is what Williamson (1995: 230) refers to as the fundamental
transformation ‘of what had been a large numbers bidding competition at the outset into one of
bilateral exchange during contract execution and contract renewal intervals.’
From the perspective of the supplier, the outsourcing of primary activities offers
opportunities for smaller firms, particularly those in developing countries, to specialise in the
labour-intensive stages of a production process which, as a whole, may be capital or technologyintensive (Yeats, 1997). Subramani and Venkatraman (2003: 58) suggest that suppliers, who are
vulnerable to the ex ante exercise of power by more powerful firms, may be able to craft
governance mechanisms such as quasi-integration and joint decision-making that safeguard ex
post their relationship-specific assets by increasing buyer switching costs.
There is considerable scope for future work on this topic. First, the various propositions
put forward in this paper should be tested using data on a cross-section of firms. These analyses
should also be extended to a variety of countries as it is likely that the potency and sustainability
14
On the other hand, Liebeskind (1996) notes that firms may prefer to remain vertically-integrated rather than risk
the loss of proprietary information.
15
In this regard, it is interesting to note that Benetton – often cited as the archetypal network organisation – has
recently instituted direct control over key purchases throughout its production chain (Camuffo et al, 2001).
26
of the isolating mechanisms will vary in different institutional environments (Priem and Butler,
2001).
Second, the concept of power needs to be refined theoretically and validated empirically.
In a study of the effects of power on profitability in the supply chains of French manufacturing
firms, Cool and Henderson (1998) identified multiple dimensions of both supplier and buyer
power. Interestingly, from the point of view of this paper, they found that buyer power explained
a much larger percentage of the variance in seller profitability than did seller power.
Third, there is a considerable literature on the management of firms’ relationships with
independent suppliers (see, for example, Levy, 1995; Kotabe, 1998; Murray, 2001; Kotabe and
Murray, 2004). But how are relationships managed and coordinated between parties in
outsourcing relationships (Mayer and Salomon, 2006; Tadelis, 2007), and how are such
mechanisms circumscribed by suppliers’ and/or buyers’ participation within other chains in
broader production networks?
Fourth, there are numerous policy issues related to the gainers and losers from the process
of the outsourcing of primary activities. For instance, what are appropriate strategies for firms
entering international production chains? Should policy-makers in developed countries be
concerned about the greater international fragmentation of production, or is outsourcing yet
another manifestation of the old adage that ‘it’s the rich what gets the pleasure and the poor what
gets the blame’? Does outsourcing provide lead firms with a hedge against workplace militancy
and union pressure (Coffee and Tomlinson, 2004)? To what extent do lead firms, which have
outsourced the production of primary activities, have responsibility for human welfare throughout
production chains that are under their effective control (Kolk and van Tulder, 2002; Adams,
2002)? To what extent does outsourcing involve the transfer of environmental problems (e.g.
pollution, carbon emissions) to other (often overseas) members of the production chain? Whilst
27
lead firms may be able to leverage their power and drive down wages and costs in their suppliers,
should they pay more attention to ethical issues?
In conclusion, the main contribution of this paper has been to combine the insights of
resource dependency theory, the resource-based view of the firm, and transaction cost economics
to provide both an explanation for the outsourcing of primary activities and a set of testable
propositions about firms’ propensities of outsource. TCE addresses the conditions under which
particular exchanges might be effected through the market rather than within a verticallyintegrated firm, but does not explain why an outsourcing relationship might be chosen by the lead
firm. Resource dependency theory emphasises that power underpins the outsourcing relationship,
but does not say much about the sources of that power, whilst the resource-based view identifies
the requirements for sustained rent generation from scarce resources. All three theories are
needed to explain outsourcing. We have argued that outsourcing should not be viewed as a
simple example of a ‘make or buy’ decision, but that it is also necessary to take into account the
power asymmetries between the parties within the production chain, and we have drawn on the
work of Rumelt (1984, 1987) in identifying isolating mechanisms that potentially enable parties
to appropriate rents from scarce resources. Furthermore we have suggested that the development
of new communications and information technologies, and in particular the internet, has both
eroded the potency of many of these isolating mechanisms with the result that power has shifted
from suppliers to buyers in the chain, and also reduced many market transaction costs. The result
has been the greater outsourcing of primary activities by many firms in many industries.
28
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Figure 1:
The Potential Power Structures
Relative scarcity of B’s resources
-----------------------------------------------------------------Low
High
--------------------------------------------------------------------------------------------------------------Low
A and B independent
B has power over A
Relative scarcity
of A’s resources
High
A has power over B
A and B interdependent
---------------------------------------------------------------------------------------------------------------
Figure 2:
The Potential Organisational Outcomes with High Market Transaction Costs
Relative scarcity of B’s resources
-----------------------------------------------------------------Low
High
--------------------------------------------------------------------------------------------------------------Low
Long-term contract,
or strategic alliance
Forward vertical
integration
Relative scarcity
of A’s resources
High
Backward vertical
Joint venture
integration
---------------------------------------------------------------------------------------------------------------
Figure 3:
The Potential Organisational Outcomes with Low Market Transaction Costs
Relative scarcity of B’s resources
-----------------------------------------------------------------Low
High
--------------------------------------------------------------------------------------------------------------Low
Competitive market
exchange
Outsourcing
High
Monopoly
Bilateral monopoly
Relative scarcity
of A’s resources
---------------------------------------------------------------------------------------------------------------